Political Relationships, Global Financing and Corporate Transparency

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Political Relationships, Global
Financing and Corporate Transparency
Christian Leuz
Felix Oberholzer-Gee

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Political Relationships, Global Financing
and Corporate Transparency

Christian Leuz
Felix Oberholzer-Gee

The Wharton School
University of Pennsylvania

May 2003

This study examines the financing choices of firms operating in a weak institutional
environment. We argue that in relationship-based systems, global financing and strong political
connections are alternative means to create firm value. Well-connected firms might be less
inclined to access global capital markets because (state-owned) domestic banks provide capital at
low cost. Moreover, the expanded disclosures and additional scrutiny that come with issuing
foreign securities might be at odds with close political ties at home because these ties can best be
exploited when little is disclosed about the firm. Using data from Indonesia, we provide strong
support for the hypothesis that global financing and political connections are substitutes: Firms
with close political ties to former President Soeharto are significantly less likely than non-
connected firms to have publicly traded foreign securities. To study performance effects, we
examine how returns during the Asian financial crisis differ between firms with and without
foreign securities. Consistent with prior work, we find that firms with foreign securities exhibit
higher returns during the crisis. However, our data indicate that politically well-connected firms
also received considerable support during this period. These results suggest that previous
estimates of cross-listing benefits are considerably biased if domestic opportunities such as
political connections are ignored.

JEL classification:
P16, G32, G38, K22, K42, M41, G18
Key Words:
Disclosure; Cross listing; Financing choices; Emerging market economies; Asian
financial crisis; Indonesia; Cost of capital

We thank Michael Backman, Alexander Dyck, Mara Faccio, Ray Fisman, Tarun Khanna, Jordan Siegel, Benny
Tabalujan and Peter Wysocki as well as seminar participants at the EAA annual meeting, the Harvard Business
School and the Wharton School for helpful comments. We are grateful to Simeon Djankow and Ray Fisman for
sharing data. Arief Budiman, Shanshan Cao, Robert Irwan, Randy Jusuf and Julie Wong provided excellent
research assistance.

In designing their corporate strategies, firms systematically seek to anticipate and exploit
opportunities in their business environment. While many of these opportunities present
themselves in markets, firms can also create value by investing in political relationships (Stigler,
1971; Krueger, 1974; Peltzman, 1976; Baron, 2001). This latter possibility is particularly
attractive in economies that are based on personal connections rather than arms-length
transactions in markets (Rajan and Zingales, 1998). In this paper, we explore the link between a
firm’s domestic opportunities and its foreign financing decisions. In particular, we ask if the
pursuit of political connections changes the likelihood that firms operating in a weak institutional
environment access global capital markets.
We study this question for two reasons. Ever since the liberalization of capital markets,
foreign capital has become an increasingly important source of finance for these firms (Karolyi,
1998). In the mid 1990s, Asian firms raised $1 in foreign equity markets for every $3 they raised
domestically (Bekaert, Harvey and Lumsdaine, 2002). Thus, it is important to understand which
firms are likely to take advantage of this new opportunity. More importantly, the decision to
issue securities that are traded on foreign markets often forces firms to adapt to the rules and
institutions of these markets. Firms that issue foreign securities come under the scrutiny of
foreign regulators, financial analysts and foreign institutional investors. Thus, the decision to
finance the firm globally carries important implications for the availability of information and
perhaps the quality of corporate governance, two important determinants of financial market
development (La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1997 and 2000). These
informational consequences of global financing are the second reason for our interest in
emerging-market firms’ decision to access foreign capital markets.


In this paper, we argue that firms’ domestic opportunities such as political connections are
likely to interact with their foreign financing decisions. However, it is a priori not obvious
whether firms with strong political connections are more or less likely to access global capital
markets. There are good theoretical reasons to believe that firms with stronger political
relationships are less likely to finance themselves globally. In emerging economies, close
political ties often offer access to low-cost financing from (state-owned) banks. The lower the
costs of domestic capital, the weaker are the incentives to access foreign markets. Moreover, the
greater disclosure that comes with issuing foreign securities may be particularly costly for firms
with close political ties because higher levels of transparency are difficult to reconcile with the
benefits that good political connections can confer. For instance, in many weakly regulated
markets, firms are free to engage in undisclosed related-party transactions benefiting controlling
insiders and political backers. But transactions of this type have to be reported once the firm’s
securities are traded on a major U.S. exchange. These arguments suggest that political
connections and global financing are substitutes.
On the other hand, there are equally valid arguments that well-connected firms are more
likely to have foreign securities. Close political ties afford more attractive business opportunities
and increase firm value (Fisman, 2001; Faccio, 2002). Hence, closely connected, fast growing
firms with a high demand for capital might find it particularly attractive to tap into foreign
markets. From the perspective of foreign investors, valuable well-connected firms might be the
most interesting investment opportunities an emerging-market economy has to offer. These
arguments suggest that close political ties and access to foreign capital markets are complements.
In view of the conflicting arguments, the relation between firms’ financing strategies and
their political connections is ultimately an empirical question. In this paper, we examine this


relation using data from Indonesia. Indonesia’s crony capitalism under former President
Soeharto provides a particularly suitable setting to examine firms’ transparency choices. First,
Indonesia has low levels of mandatory disclosure, providing more discretion to firms and
increasing cross-sectional variation in transparency. Second, there is ample evidence that the
Soeharto regime provided substantial economic benefits to politically well-connected firms
(Fisman, 2001). Third, Indonesia’s relatively centralized power structure during the Soeharto era
facilitates the measurement of political connections. And finally, the Asian financial crisis
towards the end of the Soeharto era provides an economic shock that we can exploit to assess the
performance consequences of transparency and political connections (Mitton, 2002).
In our analysis, we find strong support for the view that foreign securities and close political
connections are substitutes, i.e., two alternative means to increase firm value. Firms that are
close to the Soeharto regime are significantly less likely to have publicly traded securities
abroad. They are also less likely to have debt or equity securities traded on US exchanges.
These findings hold after controlling for firm size, financial leverage, firm profitability, and
industry characteristics.
There are at least three explanations for our results. First, it is well known that Indonesian
firms with close ties to the regime had preferential access to financing, typically from state-
owned banks (Backman, 2001). Once such funds become available, the benefits of foreign
securities are simply smaller. Second, foreign securities require greater transparency, which is
likely to impede politically arranged financing via covert operations with state-owned banks.
And third, low transparency facilitates the extraction of private benefits of control, which has
been suggested as another reason why firms from countries with weak institutional structures do


not cross list in the US despite evidence of substantial cross listing benefits (Doidge, Karolyi and
Stulz, 2001; Reese and Weisbach, 2002).
These three explanations are not mutually exclusive, and it appears likely that all of them
influence firms’ financing strategies. While our data do not allow us to distinguish between
these various mechanisms, our main finding that firms trade off political connections and access
to global capital alone has important empirical implications. A key question in the recent
literature on cross listing is whether or not foreign securities are effective legal bonding devices
which commit firms operating in weak institutional environments to better corporate governance
(Fan and Wong, 2001; Doidge et al., 2001; Reese and Weisbach, 2002; Siegel, 2002). In support
of this view, Mitton (2002) reports that Asian firms with higher-quality disclosures have
significantly higher returns during the Asian financial crisis. However, if domestic sources of
firm value – for instance President Soeharto’s attempts to save firms close to the regime – are
omitted from these analyses, the resulting estimates are likely to be biased.
There is some anecdotal evidence that Soeharto tried to protect well-connected firms. The
Texmaco group for example received loans in excess of US$ 1 billion from Bank Negara
Indonesia, one of Indonesia’s largest state banks. The loans far exceeded the bank’s legal
lending limit, but were approved by Soeharto “as a means to prop up the conglomerate after the
Asian financial crisis” (Solomon, 1999). Texmaco’s founder, Marimutu Sinivasan, is said to be
a long-time friend of President Soeharto. Consistent with such examples, our analysis shows that
the performance effects associated with foreign securities increase considerably once we control
for a firm’s closeness to the Soeharto regime, indicating that both greater disclosure and political
connections contributed to firm value during the crisis. This result is consistent with and
complements recent evidence by Johnson and Mitton (2003) showing that politically well-


connected firms in Malaysia benefited from the imposition of capital controls during the Asian
While our study suggests that political favors of dubious legality could be one of the reasons
why well-connected firms are reluctant to issue foreign securities that come with additional
disclosures, the link between political ties and global financing has consequences for corporate
transparency even if the increased disclosure does not cause firms to stay at home. Because
strong political ties discourage firms from issuing publicly traded foreign securities – the main
insight of this study – corporate transparency is less likely to improve in countries where
political connections play an important part in economic activity.
The paper is organized as follows. Section 2 describes the institutional setting and explains
our research design. Section 3 describes the sample and the data. Section 4 presents the results
for firms’ transparency choices and Section 5 reports the performance tests. Section 6 concludes
the paper.
2. Institutional Setting and Research Design
A key premise of our approach is the idea that political connections constitute a source of
firm value. There is empirical evidence supporting this view, both for Indonesia (Fisman, 2001)
and for a larger set of economies. For instance, connected firms pay fewer taxes and have larger
market shares (Faccio, 2002). In Indonesia, the Soeharto regime often arranged preferential
financing for well-connected firms (so-called “memo-lending”). An example of the early 1990s
is Golden Key, a little-known chemical and manufacturing group, which received an unsecured
loan of $430 million from the state-owned Bank Pembangunan Indonesia. Court proceedings
subsequently revealed that Hutomo Mandala Putra, the youngest son of President Soeharto, was


an early investor in Golden Key and had introduced the firm to bank officials who approved the
loan at “neck-breaking speed” (McBeth, 1994). Similarly, the Barito Pacific group received
huge loans from state banks prior to the crisis. Political connections are widely cited as the
reason behind the state banks’ generosity (Borsuk, 1993).
The benefits of political connections are not confined to debt financing. Barito Pacific’s
1993 public stock offering, for instance, was greatly helped by the state civil-service pension
fund acquiring a 20% stake. Barito denied allegations that it needed the pension fund’s entry to
“shore up the company before it could go public,” but analysts noted that the fund’s investment
substantially boosted the company’s capital (Borsuk, 1993). A further source of value for
politically well-connected firms is the granting of important licenses. The Salim Group, one of
the largest Indonesian conglomerates, had very close ties with President Soeharto and was
awarded lucrative franchises in banking, flour milling and telecoms (Shari, 1998).
These anecdotes illustrate that political connections are one way to obtain low-cost
financing and other economic advantages. An alternative strategy for emerging-market firms to
increase value is to access foreign capital markets. The issuance of foreign securities can lower
the cost of capital, help to overcome the obstacles of segmented markets (Stulz, 1981; Erunza
and Miller, 2000), and increase the firm’s value by fostering its recognition among analysts and
investors (Merton, 1987; Lang, Lins and Miller, 2002). Some authors have also argued that
cross-listings improve corporate transparency and investor protection and hence the value of the
firm to outsiders. This claim is the subject of an ongoing debate. Cheung and Lee (1995),
Coffee (2002), Mitton (2002) and Reese and Weisbach (2002) provide evidence in favor of the
hypothesis. Fanto (1996), La Porta, Lopez-de-Silanes and Shleifer (1999), Licht (2001), McNeil
(2001) and Siegel (2002) are more skeptical.


To better understand the performance and governance effects of global financing strategies,
it is important to understand why firms choose to issue foreign securities. The incentives to do
so depend in part on the relation between the value of access to foreign capital markets and
firms’ domestic business opportunities. If cross-listed firms were equally able to exploit political
connections, we would expect firms to simultaneously invest in domestic relationships and
access foreign capital markets. However, if the issue of publicly traded foreign securities forces
firms to give up domestic business opportunities, those with good opportunities might be
reluctant to access foreign markets.
To examine the relation between political ties and corporate transparency, we analyze the
likelihood of Indonesian firms having publicly traded foreign securities. Firms that issue
publicly traded securities abroad come under the scrutiny of foreign regulators, financial analysts
and foreign institutional investors, which is likely to increase the availability of information. We
also examine which firms have debt or equity securities traded on major US exchanges. In this
case, firms have to file Form 20-F with the SEC, which requires extensive disclosures (e.g., on
related-party transactions) as well as reconciliations of net income and shareholders’ equity
under foreign GAAP to U.S. GAAP. In addition, the filing exposes firms to SEC enforcement
and shareholder litigation, and makes them subject to the record keeping and accounting
provisions of the Foreign Corrupt Practices Act (Coffee, 2002).
3. Sample and Data
Our tests require financial statement and share price data. We obtain financial data from the
Worldscope database. In 1997, the database comprises 151 Indonesian firms. We lose 13 firms
because we are unable to find share price data on Datastream. In addition, we drop 8 firms that